How Does Turnover Ratio Affect My Mutual Fund Return?

NOTE: This post is part of an ongoing education series. This information is for educational purposes only. This information does not constitute investment advice. No rational person would make investment decisions based on a blog post. Please consult with your financial advisor before taking any action.
First we get the definition of turnover from Investopedia...

The percentage of a mutual fund or other investment vehicle's holdings that have been "turned over" or replaced with other holdings in a given year.

In a mutual fund you pay your share of all trading costs. The more trades (turnover) the higher that expense is. According to the Wall Street Journal...

A study updated last year of thousands of U.S.-stock funds put the average trading costs at 1.44% of total assets...

Let's try an example to make the costs clear. If you have $10,000 in a mutual fund that makes a return of $1,000 or 10%, you would pay on average 1.44% of the $10,000 for the trading costs. You would not actually make the $1,000 (10%) you would only make $856 or 8.56% (10% - 1.44%). Keep in mind that the trading cost are NOT part of the mutual fund expense ratio (average around 1.5%) that must be reported by law. It is very hard to figure out how much a given fund spends on trades. One thing you can count on - It's not for free and all of these expenses are paid for by you.

William Harding, an analyst with Morningstar, says the average turnover ratio for managed domestic stock funds is 130 percent.

Let's take a look at an ultra low cost index fund. It has a turnover ratio of about 4-5%. If the trading cost for 130% turnover is 1.44% of your return then we can estimate that a turnover of 4-5% will cost about 0.05% of your return. So, on your $10,000 investment you can pay $144 in trading costs or $5!

The other problem with turnover is taxes. If your fund has a high turnover (over 100%) then almost all of the money you make will be taxed at your income rate. This can be as high as 35%. However, if the stocks are owned for more than a year then you would only pay capital gains rate of 15% (or less).

This is a lot of math but let's bring it all together with our $10,000 investment example above:

In an average turnover, average expense fund you could make $1000 less an expense ratio of 1.5% less trading costs of 1.44% (net $706) and could pay 35% in taxes. You only keep $491 ($706 - 35% in taxes).

In an ultra low cost, low turnover index fund you could make $1000 less an expense ratio of 0.2% less trading costs of 0.05% (net $975) and then pay just 15% in taxes. You keep $829 ($975 - 15% in taxes).